Tools of Monetary Policy

The Federal Reserve System is the central banking system of the United States. The purpose of the Federal Reserve is to strengthen the financial system. The Federal Reserve has several responsibilities it must perform in order to maintain the flow of money in America. These tasks include supervising and regulating banks, maintain a strong payments system, control the amount of currency that is made and destroyed on a day to day basis, and to implement a monetary policy (The Federal Reserve Board, 2003). It is the monetary policy that is the most important task of the Fed. The monetary policy consists of open market operations, reserve requirements, and discount window lending, what is commonly known as the discount rate (Federal Reserve Bank of New York, 2006). These three tools of monetary policy help to add security and control the economy of the United States by influencing the outcomes of inflation, economic growth, and unemployment.

The first tool of monetary policy to explore is the use of reserve requirements. The Federal Reserve requires a percentage of all deposits at a bank must be kept on hand at the bank or in a Federal Reserve Bank. The amount of cash the banks must have available is only a small fraction of their checking and savings accounts (Wikipedia.org, 2006). The reserve requirement may not seem significant but it does play an important role in our economy. A low percentage rate requires the banks to keep less money on hand allowing for more loans to be made which in turn fuels the economy. A high percentage rate requires the bank to keep more money on hand. This makes it harder for people to receive loans and causes a recession (Federal Reserve Bank of Richmond, 2006). Thankfully the Federal Reserve does not change to reserve requirements very often. Right now the reserve requirement is at ten percent and has not been changed since it was lowered in April of 1992 (Federal Reserve Bank of New York).

The second tool of monetary policy is the discount lending window. The Federal Reserve lends money to other banking institutions to place more money into the economy. Representatives from banking institutions used to have to go to the Federal Reserve in person. They would take their securities up to a window to receive a loan for the exact value of their assets, less a small rate called a discount. Bank representatives no longer have to go to the “discount window” to receive a loan. In this technological age, the Federal Reserve process most transactions electronically by telephone and computer (Federal Reserve Bank of Richmond, 2006).

Another function of the discount lending window is to set the discount, or interest, rate charged to banks for the loans they receive from the Federal Reserve. When the discount rate is raised, economic activity levels slow down. This is done to check inflation levels. When the discount rate is lowered, it stimulates economic activity causing an economic growth (Federal Reserve Bank of New York, 2006). The discount rate affects the interest rates charged to individuals and other organizations on loans they receive from banking institutions. The discount rate is rarely ever changed (Federal Reserve Bank of Richmond, 2006).

The last and most important tool of monetary policy used by the Federal Reserve is open market